Since
the dawn of time, purchasers of minority stakes in companies have had
to think hard about a basic question: What are we getting for our
money?
It's still remarkable, though, to see many of the major firms in a
single industry confront the question at once. That's what is happening
in China, where the opening of the financial sector has produced a
series of high-profile investments in Chinese banks by major Western
financial companies. In 2005, there were more than $16 billion worth of
deals, involving such heavyweights as Bank of America Corp., Royal Bank
of Scotland Group plc, Merrill Lynch & Co., UBS, American Express
Co. and Goldman, Sachs & Co. This year, Citigroup Inc., which
already holds a stake in a Shanghai bank, has been trying to secure a
major position in one in Guangdong. Leading the pack is HSBC Holdings
plc -- not surprising, given its long history in the region and
familiarity to regulators there. Over the past five years, the
London-based bank, whose predecessor was founded in China nearly 150
years ago, has made no fewer than four separate investments in Chinese
financial outfits.
"We are reacting to the evolution of the China market," says Peter
Wong, executive director of HSBC's Hong Kong and mainland China
operations. "The government basically opened the door and said, 'Why
don't you [foreign banks] start investing and see what happens.' So we
invested in the Bank of Shanghai. Then they opened the door in
insurance, so we invested in Ping An Insurance. Then it was joint-stock
banks, and we invested in the Bank of Communications." If that weren't
enough, HSBC-controlled Hang Seng Bank Ltd. -- the market leader in
Hong Kong -- has also grabbed a stake in Industrial Bank Co. Ltd.
HSBC's showcase holding is its 19.9% stake in Shanghai-based Bank of
Communications, for which it paid $1.75 billion in 2004. It's a
bellwether investment in several ways. For one thing, HSBC's stamp of
approval was a key factor in June 2005, when Bank of Communications
became the first of China's banks to raise capital (in its case, $1.9
billion) in what proved to be a highly successful series of
international IPOs. At least as significant is the depth of the
business alliance the two banks are developing. HSBC has two seats on
the Bank of Communications board, has sent 31 of its executives to work
there and has also provided most of the leadership for a credit card
joint venture.
But every foreign investor has a different strategy. Their partners
range from the massive, state-owned "Big Four" banks (three of which
now have foreign investors) to the 13 national joint-stock commercial
banks to 115 city commercial banks. This July even saw the first
foreign investment in one of China's more than 30,000 rural-oriented
credit cooperatives. The size of the foreign holdings varies as well,
from a few percentage points to as much as 20%, the current limit for a
single outside investor.
And their strategic needs seem almost as diverse. Bank of America,
for example, paid $3 billion in 2005 for a 9% stake in one of the Big
Four, China Construction Bank; it profited handsomely on the bank's
$9.2 billion IPO in October 2005, but it doesn't seem to have an
extensive collaborative framework in place. Melbourne-based Australia
and New Zealand Banking Group Ltd., by contrast, bought a bigger piece
of a smaller bank -- 20% of Tianjin City Commercial Bank, known as
TCCB, in a $112 million deal that closed in July -- because it has a
strategic need to be deeply engaged in the Middle Kingdom. "China is
extremely important to Australia and New Zealand," says Bob Edgar,
senior managing director at ANZ. He adds: "China may not be quite as
aware of that as we are."
What China is acutely aware of is its need for a modern
banking system. A market economy requires banks that allocate capital
rationally -- still a new idea in China, where for decades banks have
lent billions of renminbi to sustain inefficient state industries. It
also requires banks that can succeed in an era of sophisticated
products and foreign competition; in December, the government will lift
restrictions on foreign banks doing business in local currency, as
China promised when it joined the World Trade Organization in 2001. The
foreign stakes, actively encouraged by the 3-year-old China Banking
Regulatory Commission, are one part of a huge cleanup and modernization
push that began in the late 1990s and have also included the transfer
of more than $300 billion in nonperforming loans to specially created
asset management companies and the injection of $95 billion of capital
into the Big Four banks and Bank of Communications. Rounding out the
effort are those eye-catching IPOs. Three of the country's biggest five
banks -- Bank of Communications, China Construction Bank, and Bank of
China -- have already held multibillion-dollar offerings in Hong Kong,
and Industrial and Commercial Bank of China is expected soon to follow
suit.
Foreign banks are more than eager to help with the modernization.
For starters, there are the results of those stock offerings. Royal
Bank of Scotland saw the value of its 5% stake in Bank of China more
than double after that bank's $11.2 billion listing in Hong Kong in
May. (So much profit has been made by foreign investors that some
bureaucrats have spoken out against the trend, raising worries about a
backlash against future outside investment.) But there are also the
longer-term opportunities inherent in China's $1.75 trillion worth of
domestic savings deposits. Foreigners are keen to co-develop new
products like credit cards and mortgage loans by tapping into the
existing distribution networks that partners can offer. "The simplest
way to do business in China is with a partner, because it would be very
difficult to go into a market like that and undertake the cost of
establishing a branch network, getting a customer base of hundreds of
thousands if not millions of customers," says ANZ's Edgar. "That
already exists, so why would we want to set it up again?" ANZ's
partner, TCCB, has 180 branches and assets of about $8 billion.
The foreign-Chinese partnerships are thus matches made in heaven --
in theory, anyway. In practice, the foreigners face obstacles that
start with lax credit standards (a recent surge in lending has renewed
concerns) and go well beyond. Banks in China are trying to stamp out an
entrenched culture of fraud and corruption. Their extensive reach
renders reform difficult: The Big Four operate an average of 20,000
branches apiece over China's vast geography -- outposts that in
practice may ignore top-down directives. Meanwhile, Beijing still sees
fit to intervene in important aspects of operations, using its power to
name top bank executives and even to reshuffle them at will. In July,
industry watchers were stunned when the president of Bank of
Communications, HSBC's prize partner, abruptly shifted jobs to become
vice chairman of state-owned China Construction Bank. The same month,
the president of China Construction Bank suddenly left to join the
Citic Group, also a state-run institution.
So how much effect are the foreigners actually having on their
Chinese partners? It's too early for any definitive judgments. "A lot
of the deals only closed in 2005, so it's hard now to see discernible
results," says Charlene Chu, a director at Fitch Ratings in Beijing. It
is possible, however, to compare and contrast what some of the more
ambitious foreign banks are doing to wring the greatest value out of
their investments.
| HSBC's strategic stakes |
|
Date |
Target |
Amount ($mill.) |
% Stake |
| May '05 |
Ping An Insurance
second stake |
$1,040 |
9.9% |
| Oct. '02 |
Ping An Insurance
first stake |
600 |
10.0 |
| Aug. '04 |
Bank of Communications |
1,750 |
19.9 |
| Dec. '03 |
Industrial Bank |
205* |
16.0 |
| Dec. '01 |
Bank of Shanghai |
63 |
8.0 |
*Investment made by Hang Seng Bank of Hong Kong, which is majority-controlled by HSBC
Sources: HSBC; Hang Seng; Fitch Ratings |
| |
| ANZ's alliance |
|
Date |
Target |
Amount ($mill.) |
% Stake |
| July '06 |
Tianjin City Commercial Bank |
$112 |
20% |
|
|
One obvious but still important conclusion is that
strategic partners gain influence when they take larger stakes in banks
that aren't quite so sprawling. Standard Chartered Bank, for example,
managed to land three seats on the fifteen-seat board of China Bohai
Bank, a new bank in which it invested $123 million to take a 19.99%
stake, because it was the only member of its investor consortium with
any banking experience. (It also chose its partner's vice chairman and
chief risk officer.) But Bank of America received only a single seat on
the board of China Construction Bank to go with its 9% stake in that
huge institution.
The shrewdest observer of this rule of proportionality is HSBC,
often cited as having the savviest China strategy. Admittedly, nobody
would call Bank of Communications small -- the fifth-biggest bank in
China, measured by assets, the Shanghai-headquartered institution has a
head count of nearly 60,000. It claims 2,700 branches and is one of
only 13 commercial banks with a national banking license, giving it the
ability to expand without geographical restrictions. But it's of a far
more manageable size than, say, No. 1 Industrial and Commercial Bank of
China, which has 360,000 employees. Wong says HSBC deliberately chose
to invest outside the Big Four so it would have a greater say in
operations. "The state-owned banks would be too big," says Wong.
HSBC is "very serious about having an influence on the overall
institution," says Fitch Ratings' Chu. Indeed, Chu says she wouldn't be
shocked if HSBC eventually buys the rest of BoComm, provided Beijing
lifts the current cap on such investments. "It only makes sense for
them to have a strong presence in China," she says.
This is, after all, an institution formerly known as the Hongkong
and Shanghai Banking Corp., established in both cities in 1865 and
which under British rule acted as a quasi-central bank for Hong Kong.
In 2005, Hong Kong and Asia-Pacific together accounted for one-third of
HSBC's worldwide pretax profits of $21 billion. With 24 of its own
outlets across mainland China (including 10 new branches and
subbranches just opened in 2005), HSBC boasts the biggest network of
all the foreign players. It's no surprise that HSBC -- an experienced
acquirer around the world -- was the first foreign commercial bank to
invest in China, paying $63 million for an 8% stake in Bank of Shanghai
in 2001, and has gone on to make a string of other deals (see table).
But the linchpin of its China strategy is Bank of Communications.
HSBC is working from a detailed blueprint for collaboration with its
partner, one that extends down the entire chain of command. Wong says
the two banks' chairmen meet twice a year, and a handful of top
executives meet quarterly to plot strategy. Once a year, senior
executives from both sides hash out details about how much training
HSBC will provide. HSBC sends technical consultants to advise Bank of
Communications in areas like credit, risk and human resources, and it's
training Chinese bank officers in credit risk management, auditing,
corporate governance and investor relations.
The two banks have also forged a three- to five-year plan detailing
strategy at the business unit level, based on discussions between top
business unit executives from both banks (for example, the two heads of
commercial banking). Moving down the ranks, staff often meet up to
cooperate on specific initiatives. Collaboration among business units
gets reported back to the steering committee of top executives from
both banks, who meet once a month to review ongoing initiatives.
Finally, HSBC has dispatched eight of its own bankers to assume
executive roles in BoComm's retail banking operations, including
managing credit and product and sales management. "It's very broad.
They're trying to revamp their retail banking," explains Wong.
So far, HSBC wins plaudits for its approach at BoComm and in its
other investments. "They came in early, and they were smart. There's
never been only Plan A; they've always had a few things going on at the
same time," says Chris Murck, a director of the Bank of Shanghai.
"There's a possibility of a true strategic alliance in the business
sense," adds Murck, who was formerly the Beijing-based managing
director of Chase Manhattan Bank. "I'm not sure that the investments in
banks like Bank of China or China Construction Bank will deliver that
because they're so big."
That said, even HSBC runs into situations beyond its control --
especially when it comes to sensitive personnel issues. Despite ongoing
reforms, top executives at state-owned banks still serve at the behest
of the Communist Party. So this summer, HSBC presumably could do little
when the Bank of Communications' president abruptly resigned without
public explanation and moved over to become vice chairman at rival
China Construction Bank. A spokesperson for HSBC declined to comment on
the change.
After HSBC, Citigroup is the most closely watched foreign
investor in the banking sector. It got a modest start in 2003 with the
acquisition of a 5% holding in Shanghai Pudong Development Bank (a
joint-stock commercial bank despite the "development" moniker) for $73
million. In 2005, Citigroup boosted its stake to 19.9% for around $800
million.
Less happily for Citigroup, another bid for a stake in a
medium-sized Chinese bank has highlighted Beijing's ambivalence toward
further opening of the banking sector. In an acquisition saga that has
taken multiple twists and turns over the past year, a Citigroup-led
consortium has been vying with an investor group led by Société
Générale SA for a stake in Guangdong Development Bank Co. Ltd., which
boasts a nationwide banking license and a base in the nation's richest
province.
An investment group spearheaded by Citigroup had initially sought an
85% total stake in the Guangdong bank for $3 billion, within which
Citigroup would have held a hefty 40% holding. Citigroup was hoping
authorities would bend rules that currently limit a single foreign
entity's investment in a Chinese bank to 20% and combined foreign
ownership to 25%.
But in a closely watched decision in May, Beijing nixed the bid,
signaling it is not yet ready to lift the cap on foreign investment.
There were a few reports over the summer that authorities were
considering raising the limit, but Citigroup went on to revise its
acquisition bid to the acceptable 20% limit and to enlist more Chinese
investors to join its consortium, as has Société Générale. Hoping to
gain political support, Citi also persuaded China Life Insurance Co.
Ltd., the dominant insurance company on the mainland, to sign on as one
of its consortium members. Both companies resubmitted rival offers in
July and are awaiting further word from regulators.
Other foreign financial outfits, meanwhile, seem content with
smaller share stakes and a less active role in the operations of their
Chinese partner. That's generally the case for investors in China's Big
Four. Most of these foreign banks hold stakes in the low single digits,
which doesn't allow them much say in operations. Take Bank of America,
which announced its 9%, $3 billion stake in China Construction Bank in
June 2005. (It has an option to increase its stake to 19.9%, but
observers say that could prove politically difficult.) Less than two
weeks after unveiling its China bet, Bank of America went on to
announce another deal that was no doubt a much higher strategic
priority: the acquisition of U.S. credit card giant MBNA Corp. for $35
billion.
Bank of America will, to be sure, give its Chinese partner some
input in operations. It has pledged to send about 50 staff to train
Chinese bank officers in corporate governance, risk management, IT,
financial management, human resources, retail banking (including credit
cards) and global treasury services. But while its advice will no doubt
prove helpful, it's questionable how much influence top-down training
can have on a bank with a national network of about 14,500 branches.
"Right now, it's looking like a great investment for BofA just from the
financial standpoint, but it isn't the same kind of strategic necessity
HSBC faces," says Murck.
Even as global heavyweights sign China deals, many smaller banks
have also been lining up partners, often teaming up with joint-stock
commercial banks or city commercial banks.
The 13 joint-stock commercial banks have a shorter history than the
Big Four and thus have racked up fewer bad loans; they're also allowed
to operate nationwide. By the end of 2005, seven had attracted foreign
partners, according to Fitch. Most of the 115 city commercial banks
resulted from merged urban credit cooperatives and often have
relatively weaker finances than the joint-stock banks. Though these
banks have a smaller footprint, some have been allowed to expand their
branch network into new cities. Compared to the lead four banks, banks
in both these categories are likely to offer much cheaper entry, and
their smaller size could make it easier for an outsider to push through
reforms. Also, some claim extensive branch networks in wealthy urban
areas.
ANZ invested in Tianjin City Commercial Bank, based in the
city just an hour and a half by train from Beijing. "City commercial
banks have a very strong footprint in local markets," says Edgar. "And
they're of a size which makes it practical for us to be involved and
have a serious influence on the way the banks operate."
It hardly hurts that Beijing recently tapped the Tianjin Binhai
region as the next national development zone. That puts it in league
with powerhouse regions Shenzhen and Shanghai Pudong, which the
government earlier designated as development zones.
With TCCB, says Edgar, "we were attracted to the strategic position
of Tianjin -- it's close to the capital and a port city, and we expect
it to have quite a dynamic growth profile."
Meanwhile, Tianjin's mayor, formerly the governor of China's central
bank, has been energetically promoting the region as a financial
center. It's no coincidence that Tianjin is also the site of the first
national joint-stock commercial bank to be founded in 10 years, China
Bohai Bank, which counts Standard Chartered as the sole foreign
strategic investor.
Standard Chartered, which opened its first branch in Shanghai in
1858, claims to be the oldest foreign bank in China. It also has one of
the biggest foreign networks in the nation, with offices in 14 cities.
It invested $123 million to take a 19.99% interest in the new China
Bohai Bank, which opened a headquarters office in February 2006. The
bank's other backers include a handful of non-finance-oriented local
companies such as a shipping group and a steelmaker.
The bank's investors "don't have to worry about nonperforming loans.
They can start with a blank sheet of paper and build the business
properly from day one," says Zili Shao, managing partner for greater
China at the law firm Linklaters, which advised Standard Chartered on
the deal. In June, the head of Standard Chartered's Hong Kong
operations said it was also open to considering an investment in other
banks, though it hadn't made any decisions yet.
Another noteworthy outside investor in Chinese banking is private
equity firm Newbridge Capital, the only foreign investor to have won
operating control of a Chinese bank. In 2004, it bought 18% of publicly
traded Shenzhen Development Bank Co. Ltd. for $149 million, securing a
plurality of voting shares. But outsiders caution that while the
strategy seems sound, the scale of Shenzhen Development Bank's problems
demand an investor with management control. This spring, police
reportedly detained the bank's former chairman, who left when Newbridge
took control, on suspicion that he had made illegal loan approvals.
No matter what form the collaboration takes, outside investors are
all angling for the same thing: the chance to tap into vast branch
networks through which to sell lucrative fare like credit cards and
consumer loans.
Credit cards -- still in their infancy in China -- are one of the
most promising of the new business lines. In 2004, Citigroup launched a
co-branded credit card with Shanghai Pudong Development Bank, starting
in Shanghai and requiring applicants to have incomes of at least
$6,250. The same year, HSBC and Bank of Shanghai began offering a
co-branded credit card, and last year HSBC followed up with another
co-branded card from its Bank of Communications partnership. Beyond
credit cards, HSBC plans to expand its collaboration in wealth
management as well as investment banking for Bank of Communications'
Chinese customers.
The push to fee-based products comes as Chinese banks gird for a sea
change in the way they do business. China's central bank still
basically guarantees them a healthy profit spread, known as the net
interest margin, that represents the difference between government-set
deposit rate (currently 2.52% for one-year deposits) and lending rates
(6.12% for one-year loans). But over the next few years, the People's
Bank of China plans to deregulate interest rates, echoing moves that
got under way in the U.S. in the 1980s. In America, of course, banking
deregulation was eventually to transform the industry, heightening
competition and creating the conditions for a huge wave of mergers and
acquisitions.
In China, deregulation will profoundly affect an industry that has
so far known only government coddling, forcing banks to differentiate
themselves and start responding to customers' needs.
The looming change has added urgency to Chinese banks' bids to
modernize themselves. In the meantime, foreign banks can make
themselves useful and gain a foothold in the market by offering advice
and technical assistance. They have a window of time in which to forge
strong ties with their Chinese counterparts. But assuming Chinese banks
do achieve a measure of success, there may be less need for outsiders'
help in the future.
The cleanup continues
After a decade of accelerating reforms, China's biggest banks are
looking far more presentable. Bank of Communications Co. Ltd., China
Construction Bank and Bank of China have all managed to attract an
institutional following over the past year after staging
multibillion-dollar initial public offerings in Hong Kong. Banks have
fewer bad loans on the books after the government carved out many
billions' worth and handed them off to new asset-management companies.
But a 30-year legacy of functioning largely as conduits for
government grants isn't so easily overcome. Chinese banks still look
weak compared with their international peers. And according to a June
report from Fitch Ratings, they remain acutely vulnerable to an
economic slowdown.
The China Banking Regulatory Commission, or CBRC, says nonperforming
loans at commercial banks stood at $164 billion, or 8% of total loans
outstanding, as of the first quarter of 2006. That's down from $295
billion at the end of 2003. But the improving ratio is partly due to a
rapid increase in total loans outstanding, including massive flows into
property and construction. In the first half of 2006, banks made nearly
$268 billion worth of new loans--equal to 85% of Beijing's full-year
target for lending. A downturn could turn many of those loans bad.
Problems are already pervasive amid a robust economy. Take Bank of
China, which this spring raised $11.2 billion when it staged the
fourth-biggest IPO ever in the world. Its showy debut aside, the "risk
factors" section in its prospectus ran to a wordy 20 pages. It touched
on everything from China-specific political risks to problems with
underdeveloped credit databases to looming competition from foreign
banks.
Internal corruption persists. Bank of China said in 2005 its
employees stole, embezzled and pocketed bribes to the tune of $147
million. Of 75 criminal offenses committed by Bank of China employees
last year, a third involved amounts of $125,000 or more. Though it
claims to have improved its internal controls last year, Bank of China
admitted that with a vast network of over 11,000 outlets in China and
some 600 branches overseas, it "may encounter difficulties" in rooting
out fraud.
Training is seen as the remedy. At the behest of CBRC chairman Liu
Mingkang, the American Bankers Association, a U.S. trade group, has
conducted two intensive bank training sessions in China over the past
year. The first, last November, focused on training Chinese instructors
who could carry back their knowledge to headquarters, which would then
disseminate it down the ranks. The most recent bank school, in May,
which lasted 10 days and included about four dozen attendees from all
the major banks, featured instruction in areas like performance
analysis and asset and liability management. In one simulation, teams
of students formed their own publicly listed "banks" and competed
against each other. The bank with the best stock price won.
"The WTO is driving a lot of this, the fact that at the end of '06
foreign banks will be able to operate the same way domestic banks are
able to," says Don Ogilvie, chairman of American Bankers Association
International. "The Chinese are very aware there hasn't been a
substantial financial power in the world that didn't have a successful
banking sector. So it's a challenge for them to get more competitive."
Why not go it alone?
The Chinese banking market is about to throw open the gates to
foreign competition. Starting in December 2006, under the terms of
China's accession to the World Trade Organization, foreign branches
will finally be able to apply to do business in renminbi with Chinese
consumers. Currently, foreign financial firms can provide renminbi
service only to corporate clients or foreign individuals--and then only
in specially designated cities.
So instead of taking on all the burdens of partnering, why don't
foreign banks just build their own operations, using their strong
service cultures and arsenals of financial products to claim a hefty
chunk of the market?
For a couple of reasons. First and foremost, to be a viable player
in a vast banking market still dominated by cash, a bank needs a large
branch network. Even if foreigners wanted to try to duplicate what big
Chinese banks already have, some onerous requirements impede them. To
conduct business in all currencies with wholesale and retail clients, a
bank branch must have about $50 million in operating capital. In more
liberal Hong Kong, by contrast, foreign banks need only registered
capital of $39 million at their headquarters; they don't have to make
separate operating capital allocations for each branch.
If that weren't enough of a deterrent, foreign banks in China are
permitted to open a maximum of only one branch and two subbranches a
year. No wonder foreign banks still have only a token presence in
China. At the close of 2005, 173 foreign banks had operations in 25
Chinese cities, accounting for less than 2% of banking assets.
The upshot: Foreign dealmakers in other industries may sing the
praises of Wfoes (pronounced woofies), as their wholly foreign-owned
enterprises are known. But for bankers, local partners remain a
necessity. - K.C. Swanson
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Juergen Lasowski
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